Dairy Farm - On Track For Turnaround

Maintain BUY, on track for better profitability.

We maintain our BUY rating on Dairy Farm (DFI), but lower our SOTP-based Target Price marginally to US$9.54. FY17 core profit growth was within expectations, led by strong contribution by Yonghui. We see growth driven on two fronts, namely

better margins from operationally led store efficiencies, and

earnings growth from Yonghui.

Current share price ex-Yonghui values DFI’s core business at just 17x forward PE, below the regional peer average and its 9-year historical average forward PE of 24x.

Where We Differ:

While consensus is negative on DFI, we are positive that new CEO Ian McLeod and his initiatives to improve performance of the stores will pay off over the next few years.

Already, more emphasis is placed on store operations on a more detailed basis from merchandising to display, sourcing, pricing space management, cost management etc. He also has a track record of turning around Coles in Australia.

Potential catalyst.

We see earnings turnaround going forward as a stock catalyst. We believe successful implementation of strategies by new CEO Ian McLeod will be key to earnings recovery.

Valuation

SOTP valuation methodology.

Our target price of US$9.54 is derived from sum-of-parts valuation methodology. We value DFI's core business at US$7.70 based on DCF and the 20% stake in Yonghui based on the market value of US$2.28 and net debt of US$0.45 per share.

Key Risks to Our View

Significant earnings disappointment.

We expect earnings growth to accelerate in FY18F as management brings in better operating efficiencies. We believe that earnings would have to disappoint significantly to derail our positive bias on the stock.

WHAT’S NEW - Core FY17 within expectations

Core earnings in line:

Dairy Farm International (DFI) report FY17 headline earnings of US$404m (-14% y-o-y) were below expectations. However, on a core earnings basis, net profit of US$476m was within expectations. 2H17 and FY17 saw a one-time business change cost of US$73m for the decision to exit some stores of the food business in Singapore, Malaysia and Indonesia, mainly in larger format stores and their adjustment in stock levels. Excluding these charges, FY17 net profit would be in line with our US$475m estimate.

Sales of US$11.3bn (+1% yo-y) was in line as was gross profit of US$3.4bn (+1% y-o-y).

Health and Beauty recorded sales growth of 6.6% y-o-y while operating margins increased to 8.1% y-o-y.

Expect better store level efficiency.

Core operating profit performance was largely in line with our expectations excluding the US$73m business change cost. New CEO Ian McLeod, has already rung in operational changes at both the personnel (managerial) and storefront (merchandise and display) levels. We believe that existing and new stores will be monitored more closely especially in their interface with customers, as opposed to under the previous management.

Store operations will ultimately be more efficiently managed. This has partly led to the decision to close some stores which resulted in the US$73m one-time business change cost. While the operational efficiency story is already in place, Ian McLeod as CEO and his decision to enhance operational procedures down to the store level serves to enhance the operational improvement theme.

Maintain BUY with Target Price at US$9.54.

We trimmed our FY18-19F earnings by 3-4% to account for slightly weaker but improving food division business recorded in FY17. On an exYonghui basis, DFI’s core business currently trades at 17x FY18F PE, below peer average of 24x and 9-year historical average of 25x.

Our target price of US$9.54 is based on sum-of-parts valuation methodology comprising core business at US$7.70 using DCF, 20% stake in Yonghui at market value of US$2.28 and net debt of US$0.47 per share.

Maintain BUY on the back of valuations and more positive growth going forward.

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